When Facebook paid $19 billion for messaging service WhatsApp last month, the reaction in many quarters was astonishment. How had Facebook arrived at such a mind-boggling valuation for a five-year-old firm with 50 staff?

Analysts’ explanations, that WhatsApp’s user base is growing fast and Facebook was keen to snap up the firm before a competitor acquired it, did not seem to account for the full price tag. But if $19 billion was far too high, what would the right price be? How do you value a young technology firm?

It is difficult enough for a company like WhatsApp, which by tech standards is almost geriatric. When it comes to start-ups in London’s financial technology ecosystem, many of which are younger, the task is even trickier.

Often without a revenue stream to take into account, investors are likely to base a valuation on instinct rather than advanced financial modelling techniques.

Peter Wendell, a managing director at US venture capitalist Sierra Ventures and a lecturer at Stanford University’s Graduate School of Business, said: “It’s certainly an art, not a science. If you think of mature financial services companies, they are typically valued with very clear financial metrics. In the start-up world, it’s very different because generally there aren’t a lot of metrics to use. It’s hopes and dreams.”

The number of investors trying to learn the art is rising. Annual venture capital investment in fintech in the UK and Ireland was $265 million in 2013, an eightfold increase on 2008, according to a report last week by consulting firm Accenture.

So what do venture capitalists take into account when writing a cheque for a budding fintech entrepreneur? Much of the methodology is similar to that used in pricing any other kind of early-stage company, according to investors. To estimate what a company will be worth at a future date when the investor expects to cash out, venture capitalists typically look at its growth potential, the size and attractiveness of its market, and try to compare with other similar recent deals.

The investor will then determine how much equity in the start-up his fund needs to reach the level of returns he deems rational, based on the investment’s degree of risk.

There are no strict parameters, but funds in the fintech space generally take between 15% and 25% of the companies they invest in, according to venture capitalists.

Although the same general methodology applies across sectors, venture capitalists say that there are several specific elements they look for when valuing a fintech start-up.

Delivering on objectives

One of the main factors in any early-stage valuation – albeit hardly measurable in dollar signs – is the ability of the start-up’s management team to deliver on the objectives laid out in its business plan.

This means that investors valuing a fintech company whose customers are banks will often value it more highly if its management has financial services experience, venture capitalists said.

Banks have long and complicated procurement processes and an ability to navigate the industry with confidence could prove fundamental in a company’s success.

Manu Gupta, a partner in venture capital firm Lakestar, said: “One of the most important or challenging aspects in fintech investing is that if we are selling to traditional institutions, they move at a very different pace than other tech clients. There is a tremendous advantage to having a team in a fintech company that know these people directly or they have some sort of historic relationship that could get us that meeting with senior level executives.”

Lakestar is an investor in Algomi, a London-based fintech company whose co-founder and chief executive was previously a managing director and global head of matched principal trading in fixed income at UBS. Lakestar backs around five fintech companies, and was also an investor in Skype, Facebook, Spotify and Airbnb.

Yann Ranchere, a director at digital financial services investment and advisory firm Anthemis Group, added that experience in the financial industry was also valuable because the sector is heavily regulated.

He said: “Since start-ups in fintech are somewhat difficult from a regulatory perspective, you are looking for people that will be able to manage those difficulties.”

Another important factor in early-stage valuation is what traction the company has achieved.

For fintech start-ups that sell technology to large financial institutions, even a single contract with a large bank generally carries high value, investors and advisers say.

Alexis Thieriet, a managing director at FTCL, a fintech corporate finance firm, said: “To have a major anchor client, whether it is a bank or a large exchange, proves to the marketplace that someone big has taken the product seriously and has diligenced it – to death, usually, in the case of banks – and it has passed and sold.”

Doing business with a large bank also means that while the barriers to entry will often be tougher than in consumer technology, the start-up’s technology will tend to be more embedded in its client’s systems, according to investors.

A large investment bank, for example, is unlikely to change its trade reporting systems as quickly as a consumer can switch from one shopping website to another.

Contracts with large corporates also usually last several years, giving start-ups a stream of revenue with long enough duration to be useful to investors trying to calculate value.

Hillel Zidel, a managing director at growth equity fund Kennet Partners, said investors would be willing to pay more for a company with a recurring stream of revenue.

He said: “They know that if a company doesn’t do any new sales, it can estimate what the future revenue and profitability will be based on the revenue from historical customers.”

When, as in most early-stage valuations, there are no revenues to go by, investors will be placing a lot of importance on the start-up’s intellectual property.

Tandeep Minhas, a partner at law firm Taylor Wessing, said IP was an essential part of a valuation.

Disruptive technology

She said: “Investors want to know that the IP is protected, that it is unique, and that it is either something that can be exploited in the business or potentially sold to other businesses. Having properly protected the IP is a big issue.”

Another factor is how innovative the start-up’s products are. A company that has a disruptive technology – one that forces an abrupt change in how things are done – might be a riskier investment, but might also attract a higher valuation.

Companies that sell to banks tend to provide technology where the innovation is more incremental, rather than disruptive.

Valuations also depend on how much a venture capitalist has to offer aside from money. A fund might offer less money on the basis that its team has specific skills that can help a company reach its objectives.

James Wise, a principal at venture capital firm Balderton Capital, said: “The pricing is difficult because venture funds bring different skills, depending on who they have on board.”

No matter how careful an investor’s calculations, even the most strategic assessments can be trumped by what another investor is willing to offer and whether the start-up has other suitors.

Wendell, who teaches a course on entrepreneurship and venture capital at Stanford with Google’s executive chairman Eric Schmidt, said: “It’s very much a Wild West sort of environment, where different venture capital firms can have quite different views of what a company is worth. In the end, it doesn’t matter what your view is, what matters is what the entrepreneur’s alternatives are.”

This article was first published in the print edition of Financial News dated March 31, 2014 under the headline 'Valuing a fintech start-up? Don’t forget your napkin'